CAFTA-DR’s Impact: Strengthening Central America’s Trade, but Gaps with U.S. Persist

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A Policy Research Working Paper by the World Bank’s Macroeconomics, Trade, and Investment Global Practice, authored by Sebastian Franco-Bedoya and Woori Lee, delves into the nuanced impacts of the Central America-Dominican Republic Free Trade Agreement (CAFTA-DR) on trade flows within Central America and between the region and the United States. Using a structural gravity model, the researchers examined both aggregate and sector-specific effects, accounting for varied economic relationships across countries. CAFTA-DR, which took effect from 2006 to 2009, was one of the most comprehensive regional trade agreements for Central America, aiming to boost trade both within the region and with the U.S. Through advanced statistical modeling, the authors found that CAFTA-DR notably increased trade between Central American countries by 27%. The increase in exports from Central America to the U.S. was positive but much smaller, and, interestingly, the impact on U.S. exports to Central America was statistically insignificant. The study’s findings underscore that while CAFTA-DR achieved certain objectives of regional integration, its influence on trade flows with the U.S. did not fulfill the broader expectations often associated with deep trade agreements.

Unpacking the Diversity in Trade Agreement Impacts This paper contributes to a growing body of research that investigates how trade agreements affect developing regions differently from developed economies. Whereas previous studies often apply uniform estimates of trade growth from regional trade agreements (RTAs), this analysis takes a more tailored approach by including country-specific factors and intra-national trade flows, which reflect trade within individual countries. This inclusion is particularly significant since it reveals the internal shifts in trade behavior that accompany regional agreements. By analyzing the distinct effects of CAFTA-DR on specific country pairs and sectors, the researchers highlighted that trade agreements do not yield uniformly positive results. Indeed, while the agreement promoted increased trade among Central American countries, its impact on U.S.-Central America trade flows was inconsistent. This uneven effect across trade relationships demonstrates that deeper integration does not necessarily translate to stronger trade flows across all parties, even under comprehensive agreements.

A Closer Look at Central America’s Trade Links with the U.S. Using CAFTA-DR as a case study, this analysis sheds light on the complex dynamics of trade within developing regions. Unlike the U.S.-Mexico-Canada Agreement (USMCA) or the North American Free Trade Agreement (NAFTA), which largely focused on fostering reciprocal trade gains between the U.S. and other economically advanced members, CAFTA-DR involved multiple developing economies with pre-existing trade relationships through previous agreements. Central American countries had already benefited from U.S. trade preferences, such as those under the Caribbean Basin Initiative and Generalized System of Preferences, which had facilitated duty-free access for certain goods. These historical trade preferences may explain the agreement’s modest impact on Central American exports to the U.S. CAFTA-DR was also intended to stimulate intra-regional trade among Central American nations, which the study found it did successfully. However, the effect on U.S. exports to Central America was not statistically significant, indicating that the anticipated growth in U.S. exports did not materialize to the extent expected.

Promoting Regional Production Networks through Trade One unique aspect of this study is its focus on how CAFTA-DR influenced trade dynamics within regional supply chains and the positioning of Central American countries within global value chains (GVCs). The findings suggest that CAFTA-DR supported regional production networks, particularly for intermediate goods, which are traded within Central America for further processing. This intra-regional trade expansion for intermediate goods signals that the agreement contributed to some degree of production integration within Central America. However, the positive impact did not extend significantly to final goods, especially in trade between Central American countries and the U.S. This discrepancy underscores how regional agreements may support industrialization within developing regions while not fully advancing the ambitions of external trade growth.

Assessing Anticipation Effects and Dynamic Trade Patterns The researchers also examined dynamic effects, including anticipation effects, as firms and industries adjusted to the agreement. They found that trade benefits from CAFTA-DR had already begun before the agreement fully entered into force, as Central American countries had gradually relaxed some trade restrictions. These anticipation effects suggest that businesses and policy frameworks in Central America were adapting to the expected benefits and obligations of the agreement ahead of its full implementation. Moreover, while trade gains within Central America showed a steady increase over time, the expected expansion of exports to the U.S. did not exhibit the same trend, with early adjustments giving way to an eventual plateau in trade growth. This phase-in effect is crucial for understanding how RTAs like CAFTA-DR evolve and impact trade patterns over several years, particularly in agreements that involve developing economies with asymmetrical economic relationships to a larger trading partner.

This research not only builds on limited studies of CAFTA-DR but also highlights the importance of incorporating intra-national trade flows for a more accurate understanding of trade impacts within developing regions. Previous research on CAFTA-DR did not account for domestic trade flows, which the authors argue is a critical limitation. By including domestic trade data, the study paints a more complete picture of how regional agreements affect the totality of trade relationships among members. The results reveal a heterogeneous impact, where gains in intra-regional trade were counterbalanced by limited benefits in trade with the U.S. This pattern aligns with recent literature, showing that trade gains from RTAs often display significant variation across agreements and country pairs.

The study underscores that regional agreements like CAFTA-DR can strengthen internal trade among member nations and foster regional production chains but may not guarantee enhanced trade with larger economies, especially when historical trade preferences are involved. Going forward, the authors suggest that future research and policy discussions should account for these variations, focusing on how to tailor trade agreements to support both intra-regional and extra-regional trade flows.

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